Under US GAAP debt and marketable equity seucurities have to be classified into one of the three categories:

Held-to-maturity. If the entity has the intent and the abilitiy to hold the debt security until maturity, it may classify the security as held to maturity. Since equity securities have no maturity, it only applies to debt securities. Held-to-maturity securities are reported at amortised cost calculated using the effective interest method. Therefore changes in fair value are not impacting the company’s financial statements.

Available-for-sale. This category is used for debt securities not classified as held-to-maturity or trading and marketable equity securities not classified as trading. These securities are reported at fair value on the balance sheet. Changes in fair value are not reported in net income, but directly in equity.

Trading. If a debt or marketable equity security is bought mainly for the purpose of selling in the short term it is classified as held for trading. Securities under this category are held at fair value on the balance sheet, with changes in fair value, realised and unrealised, recognised in profit or loss in the current period.

Unless they meet the definition of a security, non-derivative financial assets with determinable or fixed payments are reported under the loans and receivables category. The available for sale or trading categories only applies to securities, not to the loans and receivable category under U.S. GAAP.

 There is no classification category prescribed under US GAAP for financial liabilities.

It is important to understand how the mark-to-market movements of the securities are reflected in the financial statements, as this can explain profit and loss (p&l) volatility of the income statement. And earnings volatility often gets quite some attention by  management and investors, as higher volatility is often equated with higher risk (even if it is a result of accounting as opposed to the economics of the business). For example, imaginae a company issues debt to finance the purchase of financial instruments, let’s say bonds, on the asset side. It then classifies the assets as trading, while the liabilities backing the assets are measured on a cost basis as opposed to fair value, the m-t-m of the asset side flows through the p&l of the income statement, while the value of the liability stays stable at cost value, even though the fair value of the debt would move in tandem with the asset side and offset any gains or losses of the asset side in this case. A solution to eliminate this mismatch in valuation has been addressed by introducing the fair value option, under which some assets and liabilities items can be designated at fair value on an instrument-by-instrument basis upon initial recognition (or upon a remeasurement criteria) if certain criteria are met, which I won’t get into here.

You might wonder why companies did not just classify their securities as held-to-maturity during the financial crisis, since under the HTM category securities are carried at amortised cost on the balance sheet, in order to avoid having to recognize the unrealised losses resulting from mark-to-marketing their assets. Part of the reason is the inflexibility of selling the securities out of HTM. If such a sale occurs, the ability to classify securities as HTM is “tainted” under US GAP, forcing the entity to reclassify all securities out of HTM. This tainting lasts for at least two years for listed companies, as indicated by the SEC.

As a third option, if an entity carries its securities as AFS, there will be no p&l impact if the fair value of the securities moves up or down, as the unrealised gains and losses due to m-t-m movements are reflected directly in equity, also shown in other comprehensive income. So the same fair value movements of securities show up in different places in the financials, or not at all, depending on the classfications. These categorizations can have a big impact on the financials, therefore it is important to consider them when analyizing the financials of a company.